I left for my holidays at the start of the summer, with bond yields going down and equities performing strongly. But what a difference a summer can make. Bond yields have gone up, and equities are becoming more volatile. The market is shifting.
With a rather momentous summer behind us, I and the rest of the investment committee have debated these crosscurrents and their implications on how we invest our clients’ money. In short, with volatility looking set to continue, we have decided to stay defensive in portfolios. However, this volatility also presents opportunities along with a range of risks. Therefore, the investment committee has agreed on three actions to mitigate the former and seize the latter.
The first action is in response to the likelihood of a Eurozone and UK recession, which makes government bonds more attractive. Why? Because of the chain reaction a recession can have on bond yields. As growth slows and economies enter recession, central banks can provide stimulus by cutting interest rates. As interest rates fall, so do government bond yields. However, inflation is critical here because, as we know, spiralling inflation does not come with low interest rates. The good news is that Eurozone inflation has decisively moved past the peak, and UK inflation is also trending down, though not as much as in the Eurozone and the US. This fall in inflation means we’re close to the peak in interest rates. Therefore, we believe now is an opportune moment to capture the yield of Eurozone government bonds before central banks cut rates in 2024 to stimulate economic growth.
The second action is in response to the underwhelming rebound of China, impacting our Asia-Pacific equities position, which includes Japan. The pick-up we expected from China this year hasn’t happened. Many factors contributed to this, which we explain in our Investment Focus section below. Ultimately, the investment committee agreed that it’s unlikely we’ll see a swift turnaround in the fortunes of Chinese and broader Asia-Pacific equities. One bright spot in the region has been Japan. But the rally has been driven by the lower-quality part of the market; valuations are no longer cheap, and we think investors understand the reform and rebound story well. So, we’ve closed our position in Asia-Pacific equities and reorient it towards developed market equities.
The third action is that we’ve lowered the probability of a US recession in our forecasts, which nevertheless remains a likely outcome. If a recession does hit the US, the economic resilience we’ve seen so far suggests it’s likely to be mild. This matters because it implies that dividend cuts are less likely than we previously thought. So, the investment committee has agreed to shift our US dividend equity exposure back towards the broader US market.
Finally, as an Italian, I should mention the Rugby World Cup. We started the campaign with a record victory in the opening round, and I say this not to brag but as a reminder that, like a rugby game, the momentum in markets can shift quickly. This is why it’s crucial to stay focused on the long term and build a diversified team (or portfolio) with a broad range of attributes that can weather a range of storms. I discuss this in my latest House View blog post on portfolio diversification.
There is evidence that higher interest rates are having their intended impact: inflation is falling, and activity is slowing. And now the messaging from central bankers is beginning to point to a peak in rates. That’s not to say that the inflation battle is won, but the tide is indeed turning. We believe that central banks will keep rates elevated over the coming months to ensure there’s no inflation resurgence. These elevated rates will put pressure on economic activity, and then, as it slows, central banks will lower rates in 2024 to support growth.
As rates peak, bonds become more attractive. Historically, their yields tend to trend in line with central bank rates, as the chart below shows. Therefore, we believe now is a good time to add longer-dated Eurozone bonds to portfolios to capture this higher yield before it trends lower while also adding a cushion should the economic outlook deteriorate.
Source: In-house research, Refinitiv; Core euro yields proxied by the average between German and French benchmark government bond yields
Throughout the year, we have centred our macro outlook around the so-called “3 Ps”:
• A peak in inflation
• A pause in interest rate increases
• A pick-up in China’s economy
The first two are on track, but China’s pick-up has disappointed and turned into pessimism.
What’s happening?
The recovery in China following the opening of the economy post-pandemic hasn’t played out as we expected. We’ve spoken previously about the opportunity China had to stimulate growth as inflation was not a worry there as it has been in the West. But, so far, that stimulus has been lacklustre. Prospects looked good as China re-opened sooner than some expected, and the People’s Bank of China cut rates to boost growth. However, after a short-lived rally in Chinese equities, performance has lagged the broader global market. This disappointment is partly due to the worldwide slowdown in demand for goods, which has affected China’s exports. But there have been issues on Chinese soil, too. Retail sales, industrial production, and business investment have all slowed. Add to this a property crisis, and the outlook for China doesn’t look great.
What we’re watching
Equities look cheaper as you move from West to East across the global map. Attractive valuations may scream opportunities in Asia as investors can buy equities cheaply compared to historical averages. But there’s a reason for that. We’ve spoken about the difficulties China is facing, and the country’s risks could weigh on the broader Asia-Pacific region.
Eurozone and UK equities are fairly valued at the moment and align with historical averages. Still, given the likelihood of a recession in both regions, the risk of adding exposure to these markets is not worth taking, given the attractive yields available through less risky assets like government bonds.
That brings us to the more expensive end of the equity market, the US. The strong performance of US equities year-to-date has been driven by a concentrated group of stocks that has carried the broader market. Therefore, while US equities make up a significant proportion of our equity allocation, we hold a slightly reduced exposure relative to our long-term strategic allocation. We’re also sticking to low-volatility US equities as they offer protection in a market downturn, just like we’re maintaining our European low-volatility exposure.
Given high uncertainty, we’re sticking to low-volatility US and European equities.
Building on our position in US government bonds, we have decided to add longer-dated Eurozone government bonds. Yields are at historically attractive levels as we approach the peak in interest rates. As economic growth and inflation continue to slow, bond yields will fall, and bond prices will increase. Now is an opportune moment to lock in a decent yield for a reasonably low risk. As mentioned above, we’re keeping our overall allocation to bonds the same, so we’ve funded this trade by selling some of our shorter-term government bonds.
Turning to equities, we have decided to close our Asia-Pacific equities exposure as it has underperformed against our expectations. Deteriorating growth and smaller-than-expected support in China have continued to weigh on broader Asia-Pacific equities, including Japan. Despite China’s attractive valuations, we decided to shift back towards developed market equities, bringing our position back in line with our long-term allocation.
We are also reorienting our position in US high-dividend equities towards the broader US equity market. Here’s the thinking behind that position: if the market took a downturn, investing in stocks with a history of not cutting dividend payments would provide a cushion to portfolios. However, as the US economy has so far been more resilient than expected, we now think dividend cuts are less likely, so this market segment could continue to lag behind US equities as a whole.
N = neutral weighting of asset class vs strategic (long-term) asset allocation
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